The Defensive Investor
So You Wanna be a Value Investor?
The economy finally appears to be on stable footing. The recession is only a distant memory now as the 6-year-and-counting bull market has pushed stock markets in the United States and Europe to all-time highs. Meanwhile investors from all around the globe are raking in money. World-famous investor Warren Buffett’s net worth is over $70 billion and it seems like everyone – up to and including your little 12 year old cousin – is making money from stocks. And now you want a piece of the action.
Congratulations, because you’ve come to the right place!
First, several words of caution before we begin.
The stock market is a lot like the ocean. It can be a source of both fun and wealth, but it should never be treated like a game. It demands to be respected. On the most granular level, the stock market is just a medium used for human beings to trade ownership in companies with one another, and you would think that interactions between just two people would have at least some human element in it.
But in reality the stock market can take on a very unique personality of its own (see Ben Graham’s “Mr. Market“). The various emotions of literally millions of individual investors can combine to turn the market into an impersonal beast, willing to swallow you and your money whole, just like a riptide can pull both an inexperienced swimmer and an Olympian to the depths of the sea without judgment.
Additionally, keep in mind the words “A rising tide lifts all ships.” The bull market in the U.S. has lasted six years now. Many people have been making money in stocks, some deservedly and some undeservedly so. If you take exorbitant risks, you’ll likely make a lot of money – but you’re probably more likely to lose a lot of money too as soon as the winds shift. The real key to making money in the stock market lies in longevity, in investing within your means and inside your circle of competence, and in never losing money. Again, remember that a rising tide lifts all ships. And when the tide goes out you’ll be able to laugh at all the people who were swimming naked.
Okay enough of the public service announcement. Let’s get started!
The Defensive Investor
Since you’ve come to this site, I’m going to assume that you’re interested in value investing. Which is very smart of you. There are plenty of studies showing that value strategies outperform other types of investing strategies (especially over the long run), but you really only have to look at some of the world’s most successful investors, like Warren Buffett, Seth Klarman, and Mario Gabelli, to understand that value investing works.
This is why I’m going to use terminology from Ben Graham – the so-called father of value investing – to break this instructional post into two parts. This first article will be for who Graham called Defensive Investors. The second part will be for Enterprising Investors.
Who is a defensive investor and who is an enterprising investor?
In The Intelligent Investor, Graham has this to say about the subject:
The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort, in the form of a better average return than that realized by the passive investor.
If you immediately see yourself as an enterprising investor – solely because Graham says an enterprising investor can expect a higher return than a defensive investor – that’s good but consider this: by using the strategy that I will describe later in this article, a defensive investor can expect to earn a return equal to the overall market’s return (which has averaged 9.77% per year since 1900). Now factor in that it’s incredibly difficult to be successful as an enterprising investor: most active fund managers (generally about 60%) can’t even beat the overall market’s return.
Even Graham himself wrote that he doubted whether “a really substantial extra recompense is promised to the active investor under today’s conditions.” In today’s world, Graham would probably have been even more doubtful (see here, here, and here).
There’s absolutely nothing wrong with being a passive investor and if you have limited financial experience then I strongly suggest you stick with passive investments. I use both passive and more enterprising in my own portfolio. In Warren Buffett’s own words, “It’s pretty easy to get well-to-do slowly. But it’s not easy to get rich quick.”
Step 1: Open a Brokerage Account
Whether you’re a defensive investor or an enterprising investor, you’re going to need a brokerage account before you start investing.
Online brokerages are a great place to start looking. Many are low cost and have pretty powerful tools, including abundant educational resources. Before you decide, you’ll want to know what kind of commission fees the broker charges to buy or sell stock (most are $7-9 per trade) and you should be sure to keep an eye out for maintenance charges or other monthly fees that the broker might charge for things like minimum account balances, etc. Sometimes, trades in a firm’s own ETFs or funds will be free, so keep that in mind as well.
According to The Simple Dollar, the 4 best online brokerage accounts for 2015 are:
You might also find The Motley Fool’s broker comparison useful. Personally, I use Vanguard to invest.
Once you’ve selected a particular broker, signing up online should be fairly straightforward – usually it involves just filling out the requisite forms and transferring money from your bank account into your brokerage account. Usually that money will be “swept” into a money market fund, which is basically the equivalent of cash. You can add more money or withdraw money whenever you want. Once you’re ready to make a trade, you can place an order by calling your broker or by using your brokerage account’s website. Once the order is filled (usually within a minute or so for a market order), the shares will appear in your account. It’s really that simple!
For more information on opening a brokerage, take a look at this Motley Fool article and this Forbes article.
Step 2: Start Investing – The Defensive Investor’s Strategy
There are about 100,000 publicly traded companies in the world. In the United States, just under 4,000 companies are actively traded on the NYSE or Nasdaq, with another 15,000 traded over-the-counter (not on a major stock exchange).
This makes the process of narrowing the list to just a handful of worthy investments very daunting, and why it’s so hard for enterprising investors to beat the overall market return.
But if you’re a defensive investor, then your job is much easier.
In The Intelligent Investor, Ben Graham actually presented some simple rules for defensive investors to use when selecting individual stocks. The rules were intended to keep the process simple and to limit losses.
Unfortunately Graham died in 1976, just a year after John C. Bogle and Vanguard launched the first index fund for individual investors (watch John Bogle on the rise of index funds). If he had been alive a few years later, I’m positive that he would have recommended index fund investing as the method of choice for defensive investors (Jason Zweig, who writes the WSJ’s Intelligent Investor column and wrote the commentary for the latest edition of The Intelligent Investor book, seems to agree).
Even Warren Buffett has recommended index funds (over shares of even his own Berkshire Hathaway) to everyone from Lebron James to the trustees of his estate after he dies. His conviction in index funds for the general investor is so strong that he made a bet with several hedge fund managers in 2008 that 5 funds of their choosing would underperform the overall market over 10 years. As of February 2015, The Vanguard S&P 500 Admiral index fund Buffett chose is up 63.5% since the bet began. The five funds of hedge funds Protege picked were up roughly 19.6%.
What are Index Funds?
An index fund is type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses, and low portfolio turnover.
Investopedia explains it more fully:
“Indexing” is a passive form of fund management that has been successful in outperforming most actively managed mutual funds. While the most popular index funds track the S&P 500, a number of other indexes, including the Russell 2000 (small companies), the DJ Wilshire 5000 (total stock market), the MSCI EAFE (foreign stocks in Europe, Australasia, Far East) and the Barclays Capital Aggregate Bond Index (total bond market) are widely used for index funds. Investing in an index fund is a form of passive investing. The primary advantage to such a strategy is the lower management expense ratio on an index fund. Also, a majority of mutual funds fail to beat broad indexes, such as the S&P 500.
Basically, for very low fees, an index fund is designed to give you instant diversification while matching the return of the overall stock market. As we’ve already seen, the market’s return has averaged 9.77% since 1900. If you’re investing for the long-term, then an index fund is a no-brainer. Plus you don’t have to waste money paying an active fund manager to underperform versus the stock market.
Investing in Index Funds
So what index fund should you choose? Vanguard’s index funds are generally viewed as among the best on the market. The Vanguard 500 Index Fund (NASDAQMUTFUND: VFINX) pioneered the index-fund arena and has dutifully mirrored the returns of the S&P 500 for more than 40 years. With the fund’s low expense ratio of 0.17%, you’ll pay just $1.70 per year for every $1,000 you have invested in the fund, compared to $10 or more per $1,000 for many actively managed funds.
The Vanguard Total Stock Market Index Fund (NASDAQMUTFUND: VTSMX), owns those same S&P 500 stocks but adds small and midsized company stocks to the mix. Meanwhile, the Vanguard Total International Stock Fund (NASDAQMUTFUND: VGTSX) owns shares of companies from around the world, ranging from the largest companies in the industrialized regions of Europe and Japan to up-and-coming stocks in emerging-market countries with faster-growing economies.
Other companies, like Fidelity, also offer compelling products. It’s your job as a defensive investor to ensure expense ratios are low (usually 0.20% or lower is attractive versus the 1.00% or more charged by actively managed funds) and that the index fund actually does a good job tracking the underlying benchmark. As always, double check for hidden fees and expenses.
Although Graham wasn’t around to recommend index funds, he was a proponent of dollar-cost averaging. Dollar-cost averaging (DCA) is the technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price.
DCA is a very effective technique. A defensive investor, for example, could invest 30% of his or her paycheck in an index fund every month. Although there may be swings in the short-term, over the long-term the market will continue to rise. DCA is most effective because, by sticking to a schedule, you can avoid the common mistake of buying into the market at a peak and selling at a low. When the market is low, your fixed dollar amount will buy you more (cheap) stocks; when the market is high, your fixed dollar amount will buy you less (expensive) stocks.
Graham offers this quote from Lucile Tomlinson, who studied and wrote a book on different formula investment plans:
No one has yet discovered any other formula for investing which can be used with so much confidence of ultimate success, regardless of what may happen to security prices, as Dollar Cost Averaging.
If you’re a defensive investor, then you should be all ready to open up your first brokerage account and start investing in index funds. If you’re an enterprising investor, then be sure to come back to Vintage Value next week for Part 2 in this series.
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